Wednesday, 17 April 2013

In mid-March, WaterFurnace published its 2013 Annual Report along with the Annual Information Form and the Information Circular. The results were disappointing for investors, though we should not have been too surprised, as the last quarter exhibited a continuation of significantly slowing sales (down 13% for the total of 2012) and earnings (down 27%) that had been evident through earlier quarters.

Among the not so impressive details:

Inventory rose 15% and the finished goods portion was up 29%

Operating expenditures as a percent of sales rose from 18% to 20%

Employee compensation was up 4% (i.e. more than inflation) and executive compensation rose 49%, or 60% if director compensation, which stayed constant, is excluded; much of the exec comp came from shares issued, which diluted earnings per share a full penny; what in heaven's name justifies that sort of increase?

Warranty claims expense had a big jump up due in part to rising claim rates, not just additional units under warranty, which makes me wonder if management is building a warranty cookie jar in this non-cash item so that later the claim can be reversed with wonderful instantaneous effect on earnings.

A few positive notes:

the joint venture in China seems to have got underway quickly and successfully, being relatively close to breakeven despite a bunch of one-time startup costs

the Hyper subsidiary acquired a few years ago, contributed more to the bottom line, though it's still not large

Cost control on the manufacturing side partly offset the Opex rise

On the conference call, CEO Huntington and CFO Andriano were predictably optimistic. However past calls have conveyed the same "the light is just beginning to dawn and we are now facing an upward trend" message without coming to pass as we know.

Should we believe this optimism? A supposed key driver of sales in the USA doesn't seem to be working as the WFI managers think and say:

Housing starts - this is said to be the key for residential sales which have dropped steadily. How does falling sales jive with this YCharts graph which shows US housing starts going up slowly for the past two years.

Instead I believe it's that low natural gas prices have kicked the bottom out of the economic argument for installing a ground source heat pump system as opposed to one based on natural gas. There are a few brief comments here and there in the documents and the call about natural gas competition. Interestingly and perhaps tellingly, the AIF does not include natural gas a risk factor. Does management of the Board not believe or want to admit it? In the call, Huntington predicts natural gas prices will go up as everyone adopts it and says they have already started to firm up. Huh? Doesn't look much like it in this chart from the US Energy Administration Administration.

Bottom line: Unless the joint venture in China pays off big time and quickly, we investors (yes, I still own the stock) need to be prepared for falling sales and earnings, or stagnation at best, and probably a dividend cut from the $0.96 per share to something like $0.60. In 2012, the dividend per share was 17% more than earnings.

On that basis,
- Middle estimate: with no future growth at all and a cut in dividend to $0.60, the stock is worth around its current $16 market price.- Low estimate: If earnings fall 5% a year on average for 5 years, WFI is only worth about $13.50. High-estimate: With no growth for ten years, then 3% per year growth after that for ten years, WFI's value is $20.70 or so. (figures calculated using the discount model in this downloadable spreadsheet from McGraw Hill Investments book that I used in my original post on WFI in September 2010)

Which is more likely? Maybe the China venture will offset the US sales decline. Don't really know. Maybe I need to face sober reality, but like the alcoholic who keeps saying just one more drink, I'm still hangin' in.